The Pitfalls of Employee Leasing

The pitch is that you'll save time, money, and hassles. Don't believe it

The rationale for leasing employees, rather than hiring them directly, goes something like this. You free up executive time and eliminate costly paperwork, because the employee leasing firm takes care of administrative chores for withholding taxes, FICA, workers' compensation, unemployment insurance, and the like. And until recently, by eliminating lower-paid employees from your payroll, you could tailor your pension plan for key people without worrying about meeting nondiscrimination tests required for favorable tax treatment. (In fact, employee leasing developed largely as a result of the safe-harbor provision in the 1982 Tax Act, which said that employers wouldn't have to provide pensions for leased employees so long as the leasing companies themselves provided pensions that met certain requirements.) Leasing companies claim other advantages as well, such as better benefits for employees, available through their bulk purchasing power. And for all this you just write your leasing firm a single monthly check.

But for many companies, the benefits have turned out to be illusory. According to Ron Pilenzo, president of the American Society for Personnel Administration, there is no independent data demonstrating that employee leasing results in significant cost savings. More important, you have to give up day-to-day control of leased employees -- or you risk liability for costly obligations under certain tax and labor laws. This usually means major changes in the structure and character of your business. The leasing company, not you, must set the hours when employees work. The leasing company must provide supervisors who handle hiring, firing, evaluation, and promotion. Employees must call in sick and report other related matters to the leasing company. You can't even verify the hours your leased employees work by requiring them to submit time cards.

If you throw caution to the wind and take charge anyway, a court will almost surely decide that by so doing, you are effectively the employer and are subject to the obligations of an employer -- providing certain benefits or negotiating over employment conditions, for example. Consider the case of American Air Filter Co. (see page 2, "Too Many Bosses"). It leased employees from Transport Associates Inc., which took charge of negotiating salaries for these employees. American was then bound by the terms Transport negotiated. Further, because American had day-to-day control over the leased employees, it couldn't terminate its relationship with the leasing company when costs became too high. Instead, American had to negotiate directly with the employees' union.

Most courts consider day-to-day control over employees the key issue. Whatever your contract may say, if you supervise your leased employees, a court is almost sure to rule that you're the true employer. As another indication of whether you or the leasing company is the true employer, the courts will ask whether any leased employee you dismiss subsequently lost his or her job with the leasing company rather than being transferred to another client. If the answer is yes, you will look very much like the employer.

Similarly, if you have a cost-plus contract with an employee leasing company, a court might find that you're effectively functioning as the employer. Compensate the leasing company for every cost it incurs (salaries, benefits, business travel costs, and so on, plus a percentage fee to cover the leasing company's overhead and profits), a common arrangement, and your hoped-for advantages could be invalidated.

Even if you have an effective leasing agreement, your responsibilities for leased employees may not be significantly different than if these people were on your payroll. For instance, you'll still be subject to antidiscrimination laws that regulate hiring and firing practices, as Merrill Lynch discovered in 1984. The company had hired Tanyah Amarnare from a temporary-help agency as an administrative assistant. Clearly, Amarnare was a leased employee and intended to be purely a "temp" at that. Two weeks later, Merrill Lynch dismissed Amarnare, saying that her work was unsatisfactory. She sued, claiming that Merrill Lynch discriminated against her because she was black, a violation of the federal Civil Rights Act of 1964, by firing her without a good reason.

Merrill Lynch defended itself, saying that since it wasn't Amarnare's employer, it had no liability under the federal civil-rights law. The court disagreed. Even if Merrill Lynch wasn't Amarnare's employer, federal law would prohibit it from discriminating against her because the firing could limit her other opportunities with the temporary agency. Merrill Lynch had to stand trial, which put other companies on notice that their responsibilities to leased employees are the same as to their own employees when it comes to federal antidiscrimination law. The same reasoning applies to many state antidiscrimination laws, which tend to be more stringent than federal law.

Another concern is that if you lease employees, you'll probably give up the protection of workers' compensation laws -- leased employees can sue you for whatever amount they wish if they're injured on the job. Courts have also found that employers who lease employees must comply with the Occupational Safety and Health Administration's workplace safety regulations, since the question here is the condition of the workplace, not who the people work for.

In practice, you become a partner with the leasing company: you delegate to it authority for certain decisions and become responsible for the consequence of its errors. Of great concern is how the leasing company handles such sensitive areas as candidate selection and job interviews.

Under the federal Civil Rights Act, for instance, the use of certain kinds of tests is illegal and discriminatory if the tests eliminate a disproportionate number of minority applicants and aren't sufficiently related to the job at hand. Say your leasing company routinely administers a standard reading test to all applicants. If you're hiring for a position in which substantial reading skills aren't required, and the test eliminates a disproportionate number of any minority, you could be in trouble. The leasing company's actions could be imputed to you, and you could face charges of discrimination.

Also, federal and some state regulators say that there is statistical evidence of illegal discrimination if the people interviewed for jobs don't reflect the local population at large. So, if your leasing company's applicant pool doesn't meet this criterion and an employee who doesn't get a job files suit, you could be liable.

You may also be faced with unexpected costs if a leasing company doesn't provide a safe-harbor plan for its people: they could be entitled to benefits from your pension plan, and you could be penalized for not providing these benefits earlier. Changes in the 1986 Tax Reform Act, intended to ensure that companies don't use leasing primarily to beef up executive pensions without adding corresponding benefits for others, have made safe harbors increasingly expensive and therefore hard to come by. As a result of the 1986 law, no more than 20% of your non-key employees may be leased. And the leasing company must contribute 10% of each leased employees's salary, up from 7.5%, to a pension plan that provides for immediate participation and vesting.

Even if your leasing company offers a safe-harbor plan, in order to take full advantage of tax benefits you may have to give your leased employees other benefits such as life, accident, and health insurance. Under these new rules, leasing is likely to be attractive only to larger companies that have relatively small groups of leased employees who need little or no supervision.

With its costs and risks, employee leasing is a questionable proposition. As more and more company owners are learning from the most successful companies, better employee relations are vital if you expect to manage a lower-cost, competitive business. And better relations would seem to be difficult to come by if you're dealing with your employees through a leasing intermediary.

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Marisa Manley is a lawyer in New York City.

TOO MANY BOSSES

How one company leased and lost

American Air Filter Co. is a manufacturer and distributor of air filters, in Louisville. In 1973 it hired Transport Associates Inc. to find and lease to it qualified, bonded truck drivers. American could reject any driver it didn't like. Once it had instructed Transport to hire a driver, American treated the drivers as if they were its own employees, even though their contracts said they worked for Transport. American provided complete supervision, dispatching the drivers and directing them as they loaded and unloaded trucks.

After the truck drivers' union negotiated a new, more expensive contract with Transport in 1980, American told Transport that as its contract permitted, it was terminating the relationship. The union appealed to the National Labor Relations Board, claiming that American and Transport were the drivers' joint employers and therefore American, too, must bargain with them about dismissing employees. The administrative-law judge who heard the case agreed. Even though American's contract specified that the truck drivers worked for Transport, American exercised day-to-day control. Accordingly, it was held liable for the obligations of an employer. In effect, American had given over to the leasing company the role of negotiating salaries, yet it was bound by the terms. And it was not allowed to terminate the lease.